Operating lease on the balance sheet

Introduction

A lease is defined as a contract or part of a contract that conveys the right to use an asset for a period of time in return for a quid-pro-quo. They are considered as off-balance sheet financing items. It means that leased assets and liabilities are not reflected in the balance sheet of a company. Lessor retains the ownership of the leased asset.

As per IFRS 16,

 For the lessor, an operating lease is defined as every lease other than the finance lease.

IFRS 16 mandates lease to be termed as a finance lease if all the following conditions are met:

  • There is the transfer of ownership to the lessee at the end of the lease period
  • The lease contains a purchase option by the lessee
  • The period of the lease exceeds 75% of the economic life of the asset
  • The present value of lease payments should exceed 90% of the asset’s fair market value.

If none of these conditions is met, the lease would be classified as an operating lease.

Operating lease is used to lease for a short period of time and is similar to renting as the transfer of ownership is not involved. Periodic annual lease payments are treated as operating expenses of the company and are shown in the income statement of the company. The firm doesn’t own the asset hence, the asset is not shown in the balance sheet on the asset’s side. Depreciation is not calculated for assets taken under an operating lease. The lessee has the option either to buy the asset or return the asset to the lessor at the end of the lease period.

For the lessee, the distinction between operating lease and finance lease has been extinguished. All leases will be shown on the balance sheet as liabilities, at the future value of the present lease payments, along with the asset showing the right to use the asset over the lease period.

The advantages of operating lease are given below:

  • Greater flexibility: Companies can replace or update the assets more often hence; it provides more flexibility to the lessor.
  • There is no risk of obsolescence as there is no transfer in ownership
  • Accounting is simpler
  • Lease rentals are tax-deductible.

Features of operating lease:

  • Lessor retains the right to the ownership of the asset.
  • The lease agreement doesn’t contain bargain purchase option.
  • PV of lease payments is lease than 90% of the fair market value of the asset.
  • Lease rentals are shown as operating expenses and charged to P/L Account.
  • Lessee has the right to use only, the risk and benefits lie with the lessor. Lessee pays the costs of maintenance of the asset.
  • The term of the lease is less than 75% of economic life of an asset.

Accounting of operating lease:

Lessee records rental payments as expense in the books of accounts and lessor records the property as an asset and depreciate it over its useful life.

Impact of operating lease on financial statements:

The effect of operating lease on the balance sheet is given below:

Effect on the income statement: Lease payments will be expensed in the P/L statement.

Effect on cash flows:

  • Lease payments are deducted from cash flow from operations.
  • Operating leases do not affect the lessee’s liabilities and hence, are off-balance-sheet items
  • Footnote disclosure of lease payment for each of the lease life is required

Example of an operating lease:

Let us take the example of a company that has entered into an operating lease agreement for an asset and has agreed to a rental payment of Rs. 24000 for a period of twelve months. Since it is an operating lease accounting, the company will book the lease rentals uniformly over the next twelve months, which is the lease term. The monthly rental expense will be calculated as follows,                            

Rental expense per month = Total lease rental / No. of months = Rs.24,000 / 12 = Rs.2,000

Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month. Each month company will record the following entry:

ParticularsDebitCredit
Rental expenses A/C Dr2000 
        To Cash 2000

Operating lease accounting by both the parties:

The lessee should recognize the following during the lease period:

  • Cost of the lease in each period where the total cost of the lease would be allocated over useful life on the straight-line method
  • Any variable lease payments which have not been included in lease obligation
  • Any impairment of the right-of-use asset

The lessor should recognize the following;

  • Lease payments are charged to P/L Account over the term of the lease on the straight-line method.
  • Variable lease payments are recorded in P/L in the same reporting period of the events which caused lease transaction
  • Initial direct costs are recognized as expense over the term of the lease.

Off-balance sheet items

Introduction:

Off-balance sheet items refer to those assets and liabilities that aren’t shown on a balance sheet. However, these assets and liabilities still belong to the company though they may not be directly associated with the company.

Companies use this method of accounting to lessen the impact of ownership of certain assets and obligations of certain liabilities on their financial statements. The company keeps certain items off of their balance sheet to present a stronger balance sheet to the investors.

The company is able to do so by transferring the ownership of certain assets to other parties or by engaging in transactions that will allow them to not be reported in the financial statements under different accounting standards.

This doesn’t mean that leaving these items off of the balance sheet is done for misleading investors or any other deceptive purposes. These items can still be disclosed in the notes given in the financial statements.

Some off-balance sheet items are:

Operating Lease:

An operating lease is one of the most common examples of off-balance-sheet assets. The company owns the asset and has leased it to a lessee. So now the company only has to show the rental payments, or any other payments associated with the assets, on its financial statements.

The asset is not shown on the company’s balance sheet. Typically, at the end of the lease term, the lessee has the option of purchasing the asset.

Accounts Receivable:

Accounts receivables can also be off-balance sheet items. Almost all companies have this asset category and the default risk of this asset is the highest.

What most companies then choose to do is sell these assets to other companies, called a factor, and in turn, the factor acquires the risk associated with the asset.

Others:

Another example of off-balance sheet items would be when investment management firms don’t show the clients’ investments and assets on the balance sheet.

Other examples of off-balance sheet items include guarantees or letters of credit, joint ventures, or research and development activities.

Example:

Let’s take a look at a situation where a company may decide to opt for off-balance-sheet financing. Suppose the company wants to buy new equipment but they don’t have the funds to be able to purchase that equipment.

If the company decides to take a loan, it would lead to a debt-to-equity ratio that will look extremely off to its investors. So the company decides to lease the equipment from another entity. This will be called an operating lease.

This way the company won’t have to show an asset or a liability on their balance sheet and will just have to account for the monthly rental payments made.

The monthly rental expense will be shown in the income statement and the company would have successfully kept this asset, or a possible liability if they had borrowed the funds, off the balance sheet.

Conclusion:

Companies must follow the rules laid out by SEC (Securities and Exchange Commission) and GAAP (generally accepted accounting principles) when disclosing off-balance sheet items in the notes.

These notes are necessary for investors when they’re analyzing the financial situation of the company.

What are the key balance sheet items?

Balance sheet:

The statement of financial position, also known as the balance sheet, is one of the financial statements prepared by companies at the end of the fiscal year.

It constitutes of real account balances that do not close at the end of accounting year but rather, their balances are carried forward from one accounting period to another.

Hence, the balance sheet comprises of accumulated balances of real accounts that lie under the three major account types: assets, liabilities, and capital.

Accounting Equation:

The entire accounting system is basically based on the following accounting equation:

Assets = Shareholders’ equity + Liabilities

And the balance sheet is literally formatted in the same manner. A balance sheet has two parts, the first part reports the book value of all assets owned by the company, whereas the second part reports a sum value of equity and total liabilities of the company.

Once the balance sheet is properly prepared and formatted, and the bookkeeping and accounting have been done accurately, the value of the assets must equal the equity and liabilities value.

In other words, the total assets balance out the equity and liabilities of the company; hence the name, balance sheet.

Key items of a balance sheet:

Assets:

Assets are defined as resources owned by a company, having an economic value, which can be controlled to produce future economic benefits. They can be both, tangible and intangible in nature.

In financial accounting, assets can be categorized under two headings i.e. current and non-current. The assets are categorized according to the time period in which the economic benefits will be generated.

  • Current Assets: are assets that are expected to generate future economic benefits or convert into cash within the current financial year i.e. 12 months. Examples include cash, bank, accounts receivable, advance paid
  • Non-Current Assets: are long-term investments in resources that aren’t expected to generate cash within the current financial year i.e. 12 months.

Liabilities:

Liabilities are the amounts of money owed by the company to other individuals, organizations or banks.

These are obligations to be performed by the entity in the future by giving up economic benefits, due to transactions made in the past. Liabilities too are divided into two categories:

  • Current Liabilities: are amounts owed by the company due in the current fiscal year i.e. the next 12 months.
  • Non-Current Liabilities: are the money owed by an organization over the long-term. However, all non-current liabilities that are going to mature become categorized as current liabilities once twelve months are remaining until maturity.

Shareholder’s Equity:

Equity is the amount of money that has been invested in the company by the shareholders or stockholders.

It is also the difference between assets and liabilities implying that in case of liquidation, the amount of money returned to the shareholder would be the leftover amount received from sales of assets after deduction of liabilities cleared.

Conclusion:

Accounting is based on a double-entry system meaning that for every debit there is a credit, hence ensuring that the accounting equation or the balance sheet stays balanced at all times.

PURPOSE OF THE BALANCE SHEET

Balance Sheet is one of the Financial Statements the reveal the financial status of the business at a given point in time.

It basically lists down all Assets, Liabilities, and the overall Equity (or Capital) that has been invested into the organization.

In other words, the balance sheet is a snapshot of the overall amounts that the company owns and owes at a given point in time. Subsequently, it tells what the company is actually worth.

Organizations create Balance Sheets for a number of different reasons, which are listed below.

  • In order to assess the overall Financial Assets that a company owns.

Despite the fact that profitability is a very pivotal role in order to gauge the overall efficiency of the business, yet the Balance Sheet depicts the material impact of profitability on the overall organization.

It lists down all assets, both short-term, as well as long-term, which are owned by the organization. It is important to keep a track of the overall assets, because an increase in profitability, with no increase in assets, would not make sense.

Therefore, it is important to know the Net Assets that a company owns at a given point in time.

  • As a tool for Investors

Investors study organizations in great detail before deciding whether to invest in the venture or not.

They normally use the balance sheet as a tool to gauge the overall financial standing of the company. This is because the Balance Sheet simply lists down the Financial Assets that the company has, as well as the amount it owes to its creditors.

These aspects are used by investors to evaluate the overall potential for returns on their investment so that they are able to make a decision accordingly.

  • As a tool for Credit and Risk Management Companies

Determination of Creditworthiness continues to be a pressing cause of concern for organizations, as well as lenders across the world. Uncertainty of being paid back really deters the overall confidence that these people have when conducting business transactions.

For instance, banks, and/or other lending institutions have no way of assessing the financial health of the company, except for looking into their Financial Statements, particularly the Balance Sheet.

  • In order to conduct Ratio Analysis

Ratio Analysis is simply a comparison of the line items that are presented in the Balance Sheet. Having a consolidated list of assets, liabilities, and capital can help them to conduct Ratio Analysis, which can provide them with valuable insights regarding the aspects that need to be focused on in order to improve the financial standing.

For instance, using Liquidity Ratios, like Quick Ratio, and Current Ratio, they can determine the best course of action that needs to be taken, depending on the results.

  • Legal Obligation

Almost all companies, regardless of their size or stature are supposed to file their set of Financial Statements are the end of every Fiscal Year. This is to ensure that there is maximum transparency, and the risks of any fraudulent activity are minimized.

Common Size Balance Sheet

Common size financial statements are preparing by taking a base value for the purpose of comparison and display the result in percentages. All the values are expressed in the form of ration and percentages.

These are easy to understand and easy to compare with other companies’ financial statements.

You can compare and get results of different financial periods of the same company or different companies in the same industry.

The main idea of financial statements is to give information about the business and when to convert the normal financial statements into common-sized statements you can easily compare your assets to liabilities ratio and your gross profit to sales ratio.

The formula for the calculating the common size statements are as:

Common size % = Required Item/Base Item

For example, if your required item is account receivable and your base item is total assets then you can easily calculate the:

Common size of Account Receivables = Account Receivables/Total Assets

Example of Common size income statement:

Sales 1.00
Cost of Goods Sold 0.7
Taxes 0.1
Net Income 0.2

Common size statements are generally prepared for company income statement and balance sheet.

You can prepare for the other statements also but that would not be as perfect and informative as these two statements could be.

Balance sheet and income statement may be prepared by taking the following information.

  • Income statement rations generally prepare by taking total revenue as the base year.
  • Balance sheet items may be compare by taking the value of total assets.

Let’s have a look common size statements.

Common Size Income Statement

The value is all determined by comparing each expense with the total sales. You can change your base to whatever you want.

Now if you want analyses your income statement with some other period or some other company’s income statement. You do not need to calculate all the figures because you can just compare the percentages that you have.

Common Size Balance Sheet?

Now you can easily compare this balance sheet with another balance sheet and get your required information very easily.

Because you can compare ratios more easily than figures. The example I have shown to you is called vertical analysis.

Limitations  Common Size Financial Statements

As you have read a many benefits of common size financial statements. There are also some limitations associated.

Different companies use different accounting policies to prepare their normal financial statements and as common size statements are based on normal statements so to get better results you should adjust the values accordingly.

Every firm uses different financial years as convenient to them. So when you want to compare statements of different companies you should also check the time from which the statements belong.

Conclusion:

So there are benefits of preparing common sized financial statements but you have to look for their limitation and think for the changes before comparing and taking results.

In this way you can get very useful information for your business and identify the key areas where you can improve.

Budgeted Balance Sheet

Balance sheet:

A balance sheet is a financial statement that is prepared annually at the end of each accounting period reporting the levels of assets, liabilities, and equity that the company owns at that time. It is also called a statement of financial position as it is reporting the company’s position in the financial term.

Budgeting:

Similarly, at the end of each accounting period a master budget is made by the budgeting department.

It constitutes several small budgets such as the cash budget, the sales budget, production budget, expense budget, etc, and is then compiled into the final plan i.e. master budget.

After the preparation of the master budget, pro forma or forecasted financial statements are prepared.

These financial statements are a guideline to the company that is to be followed throughout the year in order to achieve maximum profitability.

Budgeted Balance Sheet:

Hence, a budgeted balance sheet is a financial statement that reports the expected value of assets, liabilities, and equity that a company will be held in the future.

This expected value is arrived at by making inflation adjustments or maybe increasing or decreasing capacity.

The budgeted financial statement checks whether the budgeted plan will be profitable for the company or not and whether it should go with the current budget plan or come up with another.

In order to prepare a budgeted balance sheet, each of its line items must be separately looked at.

Non-current asset:

Fixed asset or property, plant and equipment are huge investments which why they are depreciated over their lifetime.

A proper capital budgeting and investment analysis is done for the decision making regarding purchase of a fixed asset.

Hence, if there are any plans to purchase property, plant or equipment in the future, it shall be included in the current period’s fixed asset and depreciated as per the policies of company to derive the Net Book Value (NBV).

Inventory:

The closing inventory will be the value of safety stock that the company maintains every year to avoid stock-out.

Accounts receivable:

These depend on the projected sale of the year and the turnover receivable days. In order to estimate the closing accounts receivable value for a future accounting period, the company’s credit sales shall be estimated and the turnover period ratio will indicate how many months or days it takes for the customers to pay back the amount.

For example, it takes 3 months for a company’s customer to pay back. Hence, the estimated sales for the budgeted year made in November will be accounted for as accounts receivable for the year ended 31st December. 

The following format shall be followed to estimate the accounts receivable:

(+) Opening accounts receivable balance xx
(+) Budgeted credit sales xx
(-) Cash received against receivables (x)
Closing accounts receivable balance xxx

Cash:

Cash will be reported as per the cash budget prepared before.

Accounts payable:

Accounts payable are similar to accounts receivable. The estimated accounts payable closing balance would depend on the payable turnover days and the amount of credit purchases that are expected to be made as per the purchase budget. It can be calculated through the following format:

(+) Opening accounts payable balance xx
(+) Budgeted credit purchases xx
(-) Cash paid against payables (x)
Closing accounts payable balance xxx

Stockholder’s Equity:

The equity section of the balance sheet comprises of retained earnings and the common stocks/shares. Stocks are issued at their market price to finance the business.

Hence, if any such financial plans are included in the master budget then the common stock shall be increased accordingly at the estimated market price of the shares, increasing the equity section of the financial statement as well as the asset section.

The retained earning can be calculated through the following formula:

Opening retained earning + Net Profit – Drawings

The opening retained earning balance can be extracted from the previous year’s financial statement whereas the Net profit refers to the budgeted net profit that the company expects to earn in the following year.